Econ Bonds
Content
Types of Bonds: 1. 2. 3. 4. 5. Treasuries (U.S. Federal Bonds) Municipal Corporate Agency Zero-Cupon
Treasuries: Treasuries are U.S. Federal government bonds. They are considered to be zero risk. Unless the apocalypse happens the U.S. Government will be able to pay you back. There is an interest premium for inflation expectations. Treasuries are exempt from state and local taxes (but not federal income tax). They can not be redeemed before maturity and they do not have call options (except for a few exceptions from before 1985). They are traded in secondary markets. You can buy treasuries directly from the government thru treasurydirect.com Inflation-Indexed – Some Treasuries pay a face value at maturity that is adjusted for inflation. Classifications: T-Bills: Mature between 90 days and 1 year Are zero-cupon Are sold in 91-day, 182 day and 364 day maturities T-Notes: Mature between 2-10 years Are sold in 2 year, 3 year, 5 year and 10 year maturities They pay interest twice a year T-Bonds: Mature between 10-30 years Are usually sold in 30 year maturities Pay interest twice a year Munis: Munis, or Municipal Bonds are triple tax free. They are free from state, local and federal taxes. They give a lower cupon than other bonds to make up for this, though. Corporate Bonds: Corporate bonds are the riskiest kinds of fixed-income investments out there and the income generated from them is taxable but they pay a higher cupon as a result. Corporate bonds are rated. The lower the rating, the higher the cupon. They come in short term (1-5 year), intermediate term (5-15 years) and long term (15+ years). S&P and
Moody’s rate the bonds. A rating of Ba or below means that it is a “junk” bond (aka “high-yeild”). Callable – Some have “call” features, allowing the issuing firm to pay the face value and terminate the bond at will or under certain conditions. Put – The investor has the option to sell the bond back to the issuer under certain conditions. Convertible – Some have the feature that the investor can convert the bond into shares of common stock instead of cash under certain conditions. Fixed-Rate – Most corporate bonds are fixed-rate, which means that the cupon never changes. Floating-Rate – Some corporate bonds cupon changes based on some index, such as treasury yields. This provides some protection from increases in interest rates but their cupons are usually lower, and therefore their yields are usually lower. Agency: Individual government agencies issue bonds. Freddie Mac, Fannie Mae, Sallie Mae, SBA, Federal Home Loan Banks are some examples. The cupon is higher than Treasuries, but not by much. They are almost treated like treasuries. Zero-Cupon: (not on homework) Some bonds are issued at a discounted rate with no cupon. So you might buy a $100 one year zero cupon bond for $90 that will pay $100 in one year. When they pay the investor made $10. They are marketed heavily for college education savings. Holders of zeros are required to pay tax on the interest as it accrues, so they have to pay tax on money they haven’t received yet. This can be a big tax burden for some investors. Brady Bonds: (not on homework) These are US zero cupon bond backed bonds from less developed countries. They developed from a credit crisis among less developed nations in the 1970s. Savings Bonds: (not on homework) These bonds are sold at half of face value, so the price of a $50 savings bond is $25 and the price of a $100 savings bond is $50 and so forth. They are sold in denominations between $25 and $10000. They are tax free if used for the college education of a dependant. They are more liquid, since there are no penalties for cashing them in after 6 months of investing them. Face Value (or “par” value) – The principal on the bond. The amount that is printed on the bond. Cupon – Interest paid on a bond to an investor. Maturity Date – The date on which the face value of the bond comes due.
Example: You buy a $1000 bond with a 5% cupon and a 10 year maturity date (paying $1000 for it). Every year the entity who issued the bond will pay you 5% of $1000, or $50. After 10 years, on the maturity date, the entity will repay your $1000 and the bond expires. Bonds are less volatile than stocks. Bonds are traded on the open market. Price can fluctuate with S&P and Moody’s ratings, for example. You can buy a $1000 bond with a 5% cupon for $800 or for $1200. $800 or $1200 is the price of the bond (the price paid for the bond, that is). Yeild = Cupon / Price When the price goes down and the cupon stays the same the yield goes up. For example, if you bought a $1000 bond with a 6% cupon at par, the yield would be 6% (payout of $60 divided by price of $1000). If you bought a $1000 bond with a 6% cupon at the price of $800 the yield would be 7.5% (payout of $60 divided by price of $800). When Yield goes up Price goes down. YTM = Yield to Maturity YTM takes into account the price ($800), the cupon (6%), the fact that you will receive face value back ($1000) and assumes that all interest payments are reinvested. In our example, YTM = 7.73% If you are a buyer of bonds you want a high yield. If you sell bonds you want a high price. Risks: Bankruptcy of entity or Credit Risk – measured by credit ratings Inflation – measured by media, the fed, economic data, etc. “Calling” Bonds or Prepayment Risk – Means that an entity can opt to repay bonds early if it so chooses, which means that you might not get as much profit as you had hoped. Rewards: The higher the risk the higher the yield. Yield also rises as maturity dates move out. For example, a 30 year bond will have a higher yield than a 90 day bond. Yeild to Maturity (YTM): YTM takes into account the price ($800), the cupon (6%), the fact that you will receive face value back ($1000) and assumes that all interest payments are reinvested. In our example, YTM = 7.73% If current yield < YTM the bond is selling at a discount If current yield > YTM the bond is selling at a premium If current yield = YTM the bond is selling at par.
Treasuries: Treasuries are U.S. Federal government bonds. They are considered to be zero risk. Unless the apocalypse happens the U.S. Government will be able to pay you back. There is an interest premium for inflation expectations. Treasuries are exempt from state and local taxes (but not federal income tax). They can not be redeemed before maturity and they do not have call options (except for a few exceptions from before 1985). They are traded in secondary markets. You can buy treasuries directly from the government thru treasurydirect.com Inflation-Indexed – Some Treasuries pay a face value at maturity that is adjusted for inflation. Classifications: T-Bills: Mature between 90 days and 1 year Are zero-cupon Are sold in 91-day, 182 day and 364 day maturities T-Notes: Mature between 2-10 years Are sold in 2 year, 3 year, 5 year and 10 year maturities They pay interest twice a year T-Bonds: Mature between 10-30 years Are usually sold in 30 year maturities Pay interest twice a year Munis: Munis, or Municipal Bonds are triple tax free. They are free from state, local and federal taxes. They give a lower cupon than other bonds to make up for this, though. Corporate Bonds: Corporate bonds are the riskiest kinds of fixed-income investments out there and the income generated from them is taxable but they pay a higher cupon as a result. Corporate bonds are rated. The lower the rating, the higher the cupon. They come in short term (1-5 year), intermediate term (5-15 years) and long term (15+ years). S&P and
Moody’s rate the bonds. A rating of Ba or below means that it is a “junk” bond (aka “high-yeild”). Callable – Some have “call” features, allowing the issuing firm to pay the face value and terminate the bond at will or under certain conditions. Put – The investor has the option to sell the bond back to the issuer under certain conditions. Convertible – Some have the feature that the investor can convert the bond into shares of common stock instead of cash under certain conditions. Fixed-Rate – Most corporate bonds are fixed-rate, which means that the cupon never changes. Floating-Rate – Some corporate bonds cupon changes based on some index, such as treasury yields. This provides some protection from increases in interest rates but their cupons are usually lower, and therefore their yields are usually lower. Agency: Individual government agencies issue bonds. Freddie Mac, Fannie Mae, Sallie Mae, SBA, Federal Home Loan Banks are some examples. The cupon is higher than Treasuries, but not by much. They are almost treated like treasuries. Zero-Cupon: (not on homework) Some bonds are issued at a discounted rate with no cupon. So you might buy a $100 one year zero cupon bond for $90 that will pay $100 in one year. When they pay the investor made $10. They are marketed heavily for college education savings. Holders of zeros are required to pay tax on the interest as it accrues, so they have to pay tax on money they haven’t received yet. This can be a big tax burden for some investors. Brady Bonds: (not on homework) These are US zero cupon bond backed bonds from less developed countries. They developed from a credit crisis among less developed nations in the 1970s. Savings Bonds: (not on homework) These bonds are sold at half of face value, so the price of a $50 savings bond is $25 and the price of a $100 savings bond is $50 and so forth. They are sold in denominations between $25 and $10000. They are tax free if used for the college education of a dependant. They are more liquid, since there are no penalties for cashing them in after 6 months of investing them. Face Value (or “par” value) – The principal on the bond. The amount that is printed on the bond. Cupon – Interest paid on a bond to an investor. Maturity Date – The date on which the face value of the bond comes due.
Example: You buy a $1000 bond with a 5% cupon and a 10 year maturity date (paying $1000 for it). Every year the entity who issued the bond will pay you 5% of $1000, or $50. After 10 years, on the maturity date, the entity will repay your $1000 and the bond expires. Bonds are less volatile than stocks. Bonds are traded on the open market. Price can fluctuate with S&P and Moody’s ratings, for example. You can buy a $1000 bond with a 5% cupon for $800 or for $1200. $800 or $1200 is the price of the bond (the price paid for the bond, that is). Yeild = Cupon / Price When the price goes down and the cupon stays the same the yield goes up. For example, if you bought a $1000 bond with a 6% cupon at par, the yield would be 6% (payout of $60 divided by price of $1000). If you bought a $1000 bond with a 6% cupon at the price of $800 the yield would be 7.5% (payout of $60 divided by price of $800). When Yield goes up Price goes down. YTM = Yield to Maturity YTM takes into account the price ($800), the cupon (6%), the fact that you will receive face value back ($1000) and assumes that all interest payments are reinvested. In our example, YTM = 7.73% If you are a buyer of bonds you want a high yield. If you sell bonds you want a high price. Risks: Bankruptcy of entity or Credit Risk – measured by credit ratings Inflation – measured by media, the fed, economic data, etc. “Calling” Bonds or Prepayment Risk – Means that an entity can opt to repay bonds early if it so chooses, which means that you might not get as much profit as you had hoped. Rewards: The higher the risk the higher the yield. Yield also rises as maturity dates move out. For example, a 30 year bond will have a higher yield than a 90 day bond. Yeild to Maturity (YTM): YTM takes into account the price ($800), the cupon (6%), the fact that you will receive face value back ($1000) and assumes that all interest payments are reinvested. In our example, YTM = 7.73% If current yield < YTM the bond is selling at a discount If current yield > YTM the bond is selling at a premium If current yield = YTM the bond is selling at par.
